What is Risk-adjusted return on capital (RAROC) and how is it calculated ?

Risk-adjusted return on capital (RAROC) is a profitability metric that can be used to analyse return in relation to the level of risk taken on. It can be used to compare the performance of several investments with differing levels of risk exposure. RAROC was developed by Bankers Trust in the late 1970s and early 1980s in response to regulatory interest in the capital ratios of financial institutions and the implementation of capital adequacy regulations. RAROC is often used by banks to determine the amount of capital required to support the bank's activities. In business enterprises, risk is traded off against benefit. RAROC is defined as the ratio of risk adjusted return to economic capital. The economic capital is the amount of money which is needed to secure the survival in a worst-case scenario, it is a buffer against unexpected shocks in market values. Economic capital is a function of market risk, credit risk, and operational risk, and is often calculated by VaR (Value at Risk). RAROC system allocates capital for two basic reasons: Risk management Performance evaluation For risk management purposes, the main goal of allocating capital to individual business units is to determine the bank's optimal capital structure that is economic capital allocation is closely correlated with individual business risk. As a performance evaluation tool, it allows banks to assign capital to business units based on the economic value added of each unit. Risk-adjusted return on capital (RAROC) is a modified return on investment (ROI) figure that takes elements of risk into account. The formula used to calculate RAROC is: RAROC = R - E - EL + (Income from Capital/Capital) Where: R = Revenue E = Expenses EL = Expected losses Income from Capital = Capital Charges x Risk free rate